After A Drop

Here is a simple way I begin to form a basis of opinion of market direction after a substantial drop like the one we had on Friday, I simply run the numbers and backtest how the market has reacted historically following such events. So I wrote a program which looked back over the past 20 years for every instance in which the DOW closed 2.5% or more below its previous close. This system bought the cash Dow Jones Industrial Average (DJIA) and then output the percentage gains/losses of the index 1, 2, 3, 5, 10 and 20 days out. Now of course the Dow itself is not tradable but the system does give us an idea for the direction of the market in general, specifically in large cap issues. Below is a chart of the average gain for each period following a 2.5% drop and the percentage of profitable outcomes for each time frame following the drop.

	Average % Gain/Loss		% of Days Profitable
Day 1	0.85%		70.00%
Day 2	1.06%		66.00%
Day 3	1.10%		56.67%
Day 5	1.23%		60.00%
Day 10	1.33%		60.00%
Day 20	2.15%		65.52%

It turns out that the Dow has only had a loss of 2.5% or greater 30 times in the past 20 years and as you can see from the chart has bounced back surprisingly nicely following these falls. The most extreme one day moves following a drop were +4.7 and -1.74 which at least as an independent point of data holds some hope for near term upside.

These past occurrences may hold no bearing on the future but the fact that 70% of the time the DJIA posted a higher close the following trading day does seem to suggest that in the midst of substantial intraday sell-offs, such as this past Friday, traders may push the market past its short term equilibrium point after which we have seen periods of retracement and market consolidation.